Transcription

1 Chapter 7 - Put and Call Options written for Economics 104 Financial Economics by Prof Gary R. Evans First edition 1995, this edition September 24, 2011 Gary R. Evans This is an effort to explain puts and calls, which are extremely complicated. To fully benefit from this explanation, you must attempt to answer completely the questions that are asked before you move on to the next step. If you fail to do that, you will get very little from this explanation. Therefore give yourself a minimum of one hour and possibly as much as two hours to read this assignment and answer the questions. The entries below in Figure 1 appeared on September 23, 2011 on They show four call and put options for IBM, which ended trade on that day at and had risen 72 cents that day. According to the listing, the options were going to expire on November 18, The full list of all available options for any given stock is called an options chain. (If possible, the reader is advised at some point to go to or some equivalent site to look at the full options chain for IBM). These are quotations for four call and put options: IBM November 165 calls and puts and IBM November 180 calls and puts. Options used to have their own trading symbols (and technically still do) but increasingly brokerage sites just refer to calls and put by their strike price (the 165 and 180, explained below) and expiration date. This is obviously a traded security and much of the information, such as last, change, bid, ask, and volume, mean the same as they do for stocks., except the term Volume represents the number of contracts, and each single contract represents

2 Put and Call Options Page shares of stock. But what is the Strike Price? And what is meant by Open Interest? And how is the value of this security, which in the case of the 165 call, was $11.05 in the last trade, and for which there is a current Bid of $11.00 and Ask of $11.15, determined? We can start by defining a call option and a put option, although the definition may be more confusing than enlightening. So we will follow the definitions with examples. A single call option gives the owner the right to buy 100 shares of stock (IBM in this case) at the price called the strike price on or before the expiration date from the person who sold the call. For example, someone paid $3.67 per share (or $367 plus fees total) for the right to buy 100 shares of IBM for $180 on or before November 18, 2011 A single put option gives the owner the right to sell 100 shares of stock at the price called the strike price on or before the expiration date from the person who sold the put. For example, someone paid $15.30 per share (or $1,530 plus fees total) for the right to sell 100 shares of IBM for $180 on or before November 18, 2011 But why would one do this? Again, examples with questions should make this more clear (and be sure to answer the questions in your own mind or you won't get much from the reading). As an investor you have four investment options with puts and calls: 1. You may write (sell) a call option. Consider the November 180 call option listed above for $3.67 (using the Last price as the relevant price). The person who wrote (sold) this option sold to the buyer the right to buy 100 shares (or some multiple) of IBM common stock for the price of $180 (the strike price) per share on or before November 18, 2011 (the expiration date, which is always on a Friday). That right was sold for $3.67 per share, or $367 per contact, an amount pocketed by the seller after paying transaction fees. Thereafter the seller is contractually obliged to provide 100 shares of IBM for $180 per share if the buyer of the call option chooses to exercise that option on or before market close on November 18, If IBM is selling below $180 per share on the expiration date and the option has not yet been exercised, the option expires worthless to the buyer and the seller is released from any further obligation. The 180 call option, because the strike price is above the current IBM share price of $169.34, is said to be out of the money. The 165 call option is said to be in the money because the strike price is below the current price of the stock. If the writer of the call option owned IBM stock at the time the call was written then she has written a covered call and her risk is not very substantial - in fact she may have done this to reduce risk. Answer this question: Suppose you had written this 180 call on the day of this quotation after

3 Put and Call Options Page 3 you had purchased 100 shares of IBM one month earlier for $158 per share. Why would you write this call? What happens if IBM is trading at $171 on November 18 and had never risen above 180? Why would you be happy about what you had done? If the call writer does not own IBM stock at the time this call is written the contract is called a naked call contract. This can be extremely risky. Answer this question: Suppose you have written a single naked 180 call for $367, which means you earned $367 (for doing nothing except writing the contract). Suppose IBM rises to $204 before November 18 and this contract is exercised. Will you make a profit or loss? How much? You may get out of this option contract prior to the expiration date by buying a call option (effectively canceling your sale of the same) at the prevailing market price, which will likely be different from the $367 that you earned to write this call. 2. You may buy a call option written by someone else. In this case you may have been the person who bought the November 180 IBM call. If so, you have paid $3.67 per share for the right to buy 100 (or some multiple) shares of IBM for $90 on or before the November 18. Or you might have bought the November 165 call for $11.05 per share. This would give you the right to buy IBM for $165 on or before the expiration date. This in-the-money call is obviously much more valuable because it has some intrinsic worth - IBM stock is selling for $4.34 more than the price that you have the right to pay if you want to buy it. If you do buy the stock, you are said to be exercising your option. Answer this question: Why would you buy the 180 call? What will happen if the price of IBM rises to $188 per share before November 18 and you decide to exercise your option? Given that you originally invested $367, will you make a profit or a loss? How much? Answer this question: Why is the in-the-money call much more valuable than the out-of-themoney call? 3. You may write a put option. Consider the November 165 IBM put option listed above for $7.50 per share. The writer of this put option gave the buyer of the put option to right to sell you 100 (or some multiple) shares of IBM for $165 per share on or before the November 18, and you are being paid $7.50 per share for this right. The buyer will exercise this option only if IBM stock is selling for below $165 per share on or before the expiration date. If it is, then you must buy the stock at a price above its market price and take a loss. 4. You may buy a put option written by someone else. In this case, you may be the person who bought the IBM November 165 put option for 100 shares for $750. This means you have the right to sell 100 shares of IBM to the writer of this put option for $165 per share on or before the November 18, regardless of whether you currently own that stock. Because this is an out-of-themoney option, if IBM stock remains above $165 per share prior the expiration date, this option will expire worthless. The other put option listed, the November 180 that last sold for $15.30 is an in-the-money put option. Obviously in either case, the buyer of a stock option anticipates that

4 Put and Call Options Page 4 the price of the underlying stock will fall. Answer this question: What must happen for you to make a profit if you have bought the November 165 put? What will this put be worth if IBM falls to $158 per share by the November 18? Why will this put option be worthless if IBM is trading at $169 per share on the expiration date and has never gone below 165? By now it should be obvious that if you buy a call you hope that the price of the stock will rise and if you buy a put you hope that the price will fall. Frequently Asked Questions: Q: Why do these markets exist? What economic function do they perform? A: You can use put and call options for hedging - protecting an investment by reducing its risk. For example, if you own stock in a certain company, you can protect against a sudden drop in the price of the stock by buying a put option (as the price drops, the put option rises in value, neutralizing the loss). You can hedge a short position by buying a call option. They are also good (albeit risky) vehicles for speculation - they provide a form of leverage. An increase in the price of a common stock of 20% can cause the price of a related call option to triple, quadruple, or more. Q: What are the primary disadvantages of options? A: Transactions fees (brokerage costs) are high on options as a percentage of the bet, especially for out-of-the-money options, unless you are trading in large positions. Also there is sometimes a large spread between Bid and Ask (see the examples above). Spreads are narrower for heavily traded options and for some hugely traded options are sometimes only a penny. Options when bought and sold directly are risky, even though they offer high returns when the investor makes the right bet. Q: Who determines what options will be listed and what strike prices will be listed. A: The exchanges who list stock options (the largest is the Chicago Board Options Exchange - CBOE) determine which stocks are traded actively enough to generate markets in options, then make markets in these stocks. Strike prices are created on a sliding scale above and below the actual market price of the stock as it rises and falls. Q: Why would one write a covered call (first buy the stock, then write an out-of-the-money call option)? A: Writing a call option can potentially raise the return of a stock investment. First, you are paid to write the option and you get to keep the proceeds. If the stock price rises and the strike price of the call that you have written is above your purchase price of the stock, when the option is called you earn capital gains on the stock plus whatever you were paid to write the option, though possibly not as much as might have been made had the option

5 Put and Call Options Page 5 not been written. For example, suppose you had bought IBM for $158 per share, it is currently trading at $ and you had written the November 180 call for $3.67 per share. If IBM rises above $180 per share and the option is exercised, you will have earned $3.67 per share for writing the option and a $22 capital gain per share, for a total of $25.67 per share. And if the stock never rises above the strike price before the expiration date (say it falls back to the purchase price of $158 per share), you have still earned $3.67 per share for writing the option. On the other hand, you maximum gain is capped at $25.67 per share. If IBM rises to $200 per share, you are required to sell it to the option buyer for $180. Q: Once I buy or write a put or call option, am I obliged to remain in the contract until the option expires? A: No. You can always exit an option contract by making an offsetting transaction (called an offset) at the prevailing market price for that option. If, for example, you buy the November 180 call, you can later offset the transaction by selling the same call. If it has risen in value (in this case because the stock rose in value and the option followed it up) you will make a profit. Obviously if it has fallen in value you will make a loss. If it has fallen to a value of zero (which happens often with out-of-the-money options) then the loss is absolute and the option expires worthless. If you have written a naked call or put (one not backed by a long or short position in the stock) then the potential for loss is theoretically unlimited. For this reason, brokers seldom allow clients to write naked options. Q: What do the Volume and Open Interest columns represent? A: Options are sold in blocks of 100 shares each. The Volume number represents the number of 100-share contracts traded that day. For example, the 452 in the volume column for the November 165 call means that 452 of these 100-share call contracts were traded on this day, representing a call contract commitment on 45,200 shares of IBM stock at the 165 strike price. The Open Interest column represents the total number of such contracts outstanding and still in force. For example, the 566 open interest number for the same call indicates that there are presently 566 active call contracts at this strike price at the end of the day.. Because an ever larger number of traders ultimately offset their positions as expiration approaches, this number begins to decline in the final days. approaching zero before contract expiration. This number is typically above the volume number, but need not be. Q: What happens if I write a covered call and the price of the stock rises above the strike price? When will this option be exercised and when will I be required to sell my stock at the strike price? A: The owner of the option may exercise the option at any desired time so long as the price of the stock is above the strike price. Once the owner of the option expresses his desire to exercise the option, your broker will automatically sell your stock at the strike price. It

6 Put and Call Options Page 6 will just disappear from your account. Q: If I own a call option and it goes into the money, am I required to buy the stock? After all, the 180 option only cost me $367, but if I end up buying 100 shares of IBM, that would cost me $18,000. That's a lot of money. What if I don't have $18,000 in my account? A: No, of course not. You will offset the transaction before expiration if the option is in the money, selling it for whatever it is worth on that day. However if you fail to offset and forget that you own the option, then on expiration the stock is automatically sold to you whether you want it or not, If you don't have the money in your account you are going to have some real problems with your broker. Only a small percentage of options contracts are ever exercised. Most are offset. Option Premiums Again, a call option is said to be in the money if the Strike Price is lower than the current price of the stock. A call option is said to be out of the money if the Strike Price is higher than the current price of the stock. In the example above, the two options that are in the money are the 165 call and the 180 put. The other two options are out of the money. By inspection, and in-the-money option already has intrinsic value. It s worth something even if the stock remains unchanged in value. For example, the November 165 call option is intrinsically worth $4.34 ( minus 165). But the option is trading, at $11.05, at a price higher than the intrinsic value. This difference between the in-the-money option price and its intrinsic value is called the option premium. The premium is the value that the buyer is paying for the right to take the option gamble - in the case of the 165 call, for example, it's the amount extra that the buyer is paying above mere difference between the price of the stock and option's strike price. Here are the formulas for the premium on an in-the-money option (using the 165 call and 180 put as examples): Call Premium = Option Price - (Stock Price - Strike Price) $6.71 = ( ) Put Premium = Option Price - (Strike Price - Stock Price) $4.64 = ( ) Out-of the-money options have an intrinsic value of zero and so it is either said that their entire

7 Put and Call Options Page 7 value is the premium or that such options have no premium. Trading Options Compared to the stocks to which they are linked, options are relatively illiquid (trade on very low volume in most cases) and there is typically a large spread between Bid and Ask. For this reason, options should always be purchased with limit orders rather than market orders. If you were to place a market order to buy an November 180 call option contract (which you have just been advised not to do) the relevant purchase price for you would be the Ask, or $3.70 per share (or a contract price of $380 plus commission). If you were to place a market order to sell the same option, the relevant price is the Bid, or $3.70 per share. That s a $10 spread for the same option, and for less popular stocks the spread can be much higher. If buying, it makes much more sense to submit a limit order for $3.70 or $3.75 per share, in which case the order will be placed in its proper location at the top of the Bid queue.

Answers to Concepts in Review 1. Puts and calls are negotiable options issued in bearer form that allow the holder to sell (put) or buy (call) a stipulated amount of a specific security/financial asset,

Options Basis 1 An Investor can use options to achieve a number of different things depending on the strategy the investor employs. Novice option traders will be allowed to buy calls and puts, to anticipate

Reading: Chapter 17 An Option In the security market, an option gives the holder the right to buy or sell a stock (or index of stocks) at a specified price ( strike price) within a specified time period.

Basic Option Trading Strategies What is an option? Definition Option an intangible right bought or sold by a trader to control 100 shares of a security; it expires on a specific date in the future. The

THE POWER OF FOREX OPTIONS TOPICS COVERED Option basics Call options Put Options Why trade options? Covered call Covered put Hedging your position using options How to repair a trading position THE POWER

BONUS REPORT#5 The Sell-Write Strategy 1 The Sell-Write or Covered Put Strategy Many investors and traders would assume that the covered put or sellwrite strategy is the opposite strategy of the covered

CHAPTER 7 Options INTRODUCTION An option is a contract between two parties that determines the time and price at which a stock may be bought or sold. The two parties to the contract are the buyer and the

Option traders are nimble and quick... Options Trading Strategies... betting on or against volatility, hedging, leveraging (c) 2009-2013, Gary R. Evans. May be used only for non-profit educational purposes

Option Basics What is an Option? Option Theory Basics An option is a traded security that is a derivative product. By derivative product we mean that it is a product whose value is based upon, or derived

Introduction to Options By: Peter Findley and Sreesha Vaman Investment Analysis Group What Is An Option? One contract is the right to buy or sell 100 shares The price of the option depends on the price

OPTIONS MARKETS AND VALUATIONS (CHAPTERS 16 & 17) WHAT ARE OPTIONS? Derivative securities whose values are derived from the values of the underlying securities. Stock options quotations from WSJ. A call

INTRODUCTION TO OPTIONS MARKETS QUESTIONS 1. What is the difference between a put option and a call option? 2. What is the difference between an American option and a European option? 3. Why does an option

Week 1: Futures, Forwards and Options - A derivative is a financial instrument which has a value which is determined by the price of something else (or an underlying instrument) E.g. energy like coal/electricity

CHAPTER 14 Stock Options Options have fascinated investors for centuries. The option concept is simple. Instead of buying stock shares today, you buy an option to buy the stock at a later date at a price

Introduction Welcome Congratulations on getting started with the Options Trader. Did you know that in spite of all the turmoil in the financial markets as of late (or partly maybe because of it), the growth

THE EQUITY OPTIONS STRATEGY GUIDE APRIL 2003 Table of Contents Introduction 2 Option Terms and Concepts 4 What is an Option? 4 Long 4 Short 4 Open 4 Close 5 Leverage and Risk 5 In-the-money, At-the-money,

Maderas Golf Course, San Diego County, 9th hole. Your teacher brilliantly birdied this hole. He triple-bogied the one in the background. You should play golf to understand options because you learn how

OPTIONS THEORY Introduction The Financial Manager must be knowledgeable about derivatives in order to manage the price risk inherent in financial transactions. Price risk refers to the possibility of loss

Derivatives: Options Call Option: The right, but not the obligation, to buy an asset at a specified exercise (or, strike) price on or before a specified date. Put Option: The right, but not the obligation,

INSTRUCTOR S MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 9 TH ED. CHAPTER 8 SUGGESTED ANSWERS TO CHAPTER 8 QUESTIONS. On April, the spot price of the British pound was $.86 and the price of the June futures

CHAPTER 20 Financial Options Chapter Synopsis 20.1 Option Basics A financial option gives its owner the right, but not the obligation, to buy or sell a financial asset at a fixed price on or until a specified

Buying Equity Call Options Presented by The Options Industry Council 1-888-OPTIONS Equity Call Options Options involve risks and are not suitable for everyone. Prior to buying or selling options, an investor

OPTION TRADING 101 Session Objectives: Disclaimers: Expand knowledge of available tools Overview of Option Trading Not a training session for option trading Not a recommendation for trading options 2 The

Managing for Today s Cattle Market and Beyond Commodity Options as Price Insurance for Cattlemen By John C. McKissick, The University of Georgia Most cattlemen are familiar with insurance, insuring their

1 of 10 Section 1 - Overview and Option Basics Download this in PDF format. Welcome to the world of investing and trading with options. The purpose of this course is to show you what options are, how they

General Information Series 1 Agricultural Futures for the Beginner Describes various applications of futures contracts for those new to futures markets. Different trading examples for hedgers and speculators

Options on the Dow Jones Industrial Average SM DJX and DIA Act on the Market You Know Best. A glossary of options definitions appears on page 21. The Chicago Board Options Exchange (CBOE) was founded in

LEAPS LONG-TERM EQUITY ANTICIPATION SECURITIES The Options Industry Council (OIC) is a non-profit association created to educate the investing public and brokers about the benefits and risks of exchange-traded

www.optionseducation.org Options on ETFs 1 The Options Industry Council For the sake of simplicity, the examples that follow do not take into consideration commissions and other transaction fees, tax considerations,

11 Option Payoffs and Option Strategies Answers to Questions and Problems 1. Consider a call option with an exercise price of $80 and a cost of $5. Graph the profits and losses at expiration for various

Frequently Asked Questions on Derivatives Trading At NSE NATIONAL STOCK EXCHANGE OF INDIA LIMITED QUESTIONS & ANSWERS 1. What are derivatives? Derivatives, such as futures or options, are financial contracts

Stock Options Definition Contractual instruments whereby two parties enter into an agreement To give something of value to each other Option contract gives the holder the right to buy/ sell a certain amount

Section 1. Introduction to Option Trading Trading stock options is a much different game from trading the underlying stocks. When options are traded for appreciation, it is a game of leverage, with big

RECOGNIA S Guide to Options Strategies A breakdown of key options strategies to help you better understand the characteristics and implications of each Recognia s Guide to Options Strategies 1 3 Buying

Interest Rate Options A discussion of how investors can help control interest rate exposure and make the most of the interest rate market. The Chicago Board Options Exchange (CBOE) is the world s largest

StocksQuest Lesson #3: Selling Short and Buying on Margin Selling Short ~ Selling short occurs when investors sell stocks they don t actually own, they do this by borrowing stocks instead of buying stocks.

Swing Trade Warrior Chapter 1. Introduction to swing trading and how to understand and use options How does Swing Trading Work? The idea behind swing trading is to capitalize on short term moves of stocks

Options on Single Stock Futures Overview Options on single Stock Futures An SSF option is, very simply, an instrument that conveys to its holder the right, but not the obligation, to buy or sell an SSF

Investment Planning understanding options Get acquainted with this versatile investment tool. Understanding Options This brochure discusses the basic concepts of options: what they are, common investment

Short Selling Tutorial http://www.investopedia.com/university/shortselling/ Thanks very much for downloading the printable version of this tutorial. As always, we welcome any feedback or suggestions. http://www.investopedia.com/investopedia/contact.asp

Call and Put Options As you possibly have learned, the holder of a forward contract is obliged to trade at maturity. Unless the position is closed before maturity the holder must take possession of the

Understanding Options Trading ASX. The Australian Sharemarket Disclaimer of Liability Information provided is for educational purposes and does not constitute financial product advice. You should obtain

Appendix 1: Risks involved with futures trading Before executing any futures transaction, the client should obtain information on the risks involved. Note in particular the risks summarized in the following

Chapter 3.4 Forex Options 0 Contents FOREX OPTIONS Forex options are the next frontier in forex trading. Forex options give you just what their name suggests: options in your forex trading. If you have

Chapter 8 Financial Options and Applications in Corporate Finance ANSWERS TO END-OF-CHAPTER QUESTIONS 8-1 a. An option is a contract which gives its holder the right to buy or sell an asset at some predetermined

Sharechart Option Strategies Option Strategies in ShareChart December 2005 Disclaimer Indicators in ShareChart provide useful technical analysis information that can be found in many technical analysis

FIN-40008 FINANCIAL INSTRUMENTS SPRING 2008 Options These notes consider the way put and call options and the underlying can be combined to create hedges, spreads and combinations. We will consider the

Class: Options Strategies in a Bull Market www.888options.com 1.888.678.4667 This document discusses exchange-traded options issued by The Options Clearing Corporation. No statement in this document is

Options Pricing We will use the example of a call option in discussing the pricing issue. Later, we will turn our attention to the Put-Call Parity Relationship. I. Preliminary Material Recall the payoff

Page 218 The information in this chapter was last updated in 1993. Since the money market evolves very rapidly, recent developments may have superseded some of the content of this chapter. Chapter 15 OPTIONS

Chapter 24 - Options 24-1: In both cases, if the option is exercised, you will be buying the underlying shares. The difference is that the buyer of the option pays the premium to the writer for the privilege

1 of 17 Section 1 - Dow Jones Index Options: Essential terms and definitions Download this in PDF format. In many ways index options are similar to options on individual stocks, so it is relatively easy

Understanding Options Trading ASX. The Australian Sharemarket Disclaimer of Liability Information provided is for educational purposes and does not constitute financial product advice. You should obtain

EXCHANGE TRADED OPTIONS A SELF STUDY GUIDE TO TRADING EQUITY OPTIONS NZX EDUCATION This document is provided for general information purposes and is not intended as, and shall not constitute, investment

What are CFD s In finance, a contract for difference (CFD) is a contract between two parties, typically described as "buyer" and "seller", stipulating that the seller will pay to the buyer the difference

Trading for Rookies, Session I: Trading Terminology Disclaimers s involve risks and are not suitable for all investors. Prior to buying or selling options, an investor must receive a copy of Characteristics

Forsa Equity Options Traded on the Kuwait Stock Exchange Options are not suitable for everyone. In light of the risks associated with trading options, you should use them only if you are confident that

Don t be Intimidated by the Greeks, Part 2 August 29, 2013 Joe Burgoyne, OIC www.optionseducation.org 2 The Options Industry Council Options involve risks and are not suitable for everyone. Prior to buying

Options Understanding options trading Although Australian Stock Exchange Limited has made every effort to be accurate, it does not guarantee the accuracy of the information in this booklet. Accordingly

6. Foreign Currency Options So far, we have studied contracts whose payoffs are contingent on the spot rate (foreign currency forward and foreign currency futures). he payoffs from these instruments are

International Securities Exchange Whitepaper on Dividend Trade Strategies in the U.S. Options Industry March 2010 Dividend Trade Strategies in the U.S. Options Industry Key Terms Assignment Notification

FAQ ON EQUITY DERIVATIVES CONTENT 1. Trading A) How to open a trading account for commencing trading in the futures and options? B) What are the different forms / documents which are required to be submitted

Two-State Options John Norstad j-norstad@northwestern.edu http://www.norstad.org January 12, 1999 Updated: November 3, 2011 Abstract How options are priced when the underlying asset has only two possible